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Firms and broker dealers have often been penalized with fines and suspension for failing to provide an adequate due diligence review of a security offering. Many times, the issue is not a lack of information or a failure to go through the process of due diligence, but not verifying the information received.

Assumption of Responsibility for Verification

When a broker dealer conducts a due diligence review for a security offering, it is assumed that they will not only collect the necessary information, but they will verify that the information is accurate. What this means for the broker is that they must conduct a reasonable investigation. According to Notice 10-22, this cannot be accomplished by relying solely on information provided by the issuer.

Any information provided by the issuer must be verified through independent means. This often includes hiring a third party due diligence provider or independently devoting an extensive amount of time to the review of contracts and financial documents provided by the issuer. It is also necessary to review business plans and financial models and to inquire about various aspects of the business. In addition, the broker dealer should make a visit to the facilities of the issuer.

Verification of Internal Processes

Broker dealers should also develop procedures for the supervision of activities related to Regulation D offerings. These procedures ensure that a reasonable investigation has been completed prior to recommending the offering to customers and that an analysis has been done to ensure the offering is recommended to customers to which it is well-suited. Proper supervision procedures also help to protect the broker dealer and the firm from violating any antifraud provisions.

Accurate documentation throughout the due diligence process can serve to provide partial verification and to ensure that an adequate review has been conducted. This documentation should include a list of all documents reviewed.

Another aspect of verification should include a checklist that details all of the steps to be followed in the investigation. This is especially important when the broker dealer relies on a syndicate manager or counsel for part of the investigation. It is the broker dealer’s responsibility to ensure that all information gathered is accurate and that any issues have been addressed.

When a broker dealer delegates any or all aspects of the investigation to an associate, they are ultimately responsible for everything the associate does. So, if they fail to review the financial statements of the issuer or do other tasks to provide due diligence, both the associate and the broker dealer may receive disciplinary action. Verification of all information gained during due diligence ensures that a recommendation can be made in confidence and it protects the broker dealer and the firm from any negative consequences.